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GT Alert

Recent SEC Administrative Proceeding Against Hedge Fund Adviser Illustrates Classic Application of Integration Principles and Limitations on Private Offering Exemptions

August 2005

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On July 8, 2005, the U.S. Securities and Exchange Commission issued an Order instituting and settling an administrative proceeding against a hedge fund investment adviser.1 The proceeding demonstrates the increased focus of the SEC on hedge fund advisers and the hedge fund industry. Given the continued interest of Greenberg Traurig’s clients and prospective clients in investment fund activities, we prepared this GT Alert as a cautionary summary of what is a current “hot topic” at the SEC.

“The proceeding demonstrates the increased focus of the SEC on hedge fund advisers and the hedge fund industry.”

One factor that makes this case interesting is that there was no assertion of any actual harm or of any specific loss to an investor, issues usually present in such proceedings. While the alleged violations are significant in legal terms, our sense is that the case involves actions that were not driven by corrupt intentions as much as business decisions that did not comply with legal restrictions. The core of the findings is that the respondents:

  • by selling to 64 non-accredited investors in multiple entities that were integrated into one entity, violated the registration requirements for offering and sale of securities under the Securities Act of 1933, and
  • by disseminating information about the private offering over the airwaves and the internet, cannot then claim to be conducting a private offering under the Securities Act of 1933, and
  • by failing to qualify for the exemption in Section 3(c)(1) of the Investment Company Act of 1940 limiting the number of investors to not more than one hundred, violated the prohibition on sales of shares in an unregistered investment company.

A summary of the allegations is that the respondents established a hedge fund in 2000 to serve as the investment vehicle for potential clients who would not qualify to open individual accounts since they had assets that were below the minimum account level for the adviser. In 2002 the respondents established a second hedge fund. Though some differences were asserted by the respondents regarding the investment strategies of the two funds, the SEC found that the operations of the funds and the composition of their portfolios did not demonstrate any material differences that constituted a bona fide business basis for maintaining multiple entities. For this reason the SEC integrated the two funds, and integrated the two separate private offerings that offered and sold the interests in the two funds.

As we have so often noted, many hedge funds remain free of registration as investment companies under the 1940 Act by relying on the exemption provided by Section 3(c)(1). That paragraph requires that the exempt fund (i) is not conducting a public offering, and (ii) does not have more than 100 beneficial owners. To satisfy the first criteria, hedge funds typically rely on Regulation D to conduct private offerings, and therefore may not sell to more than 35 non-accredited investors. To comply with the second requirement, a hedge fund must cease the distribution of its interests at a level below 100 beneficial owners.

In this case, the SEC alleged violations of both limitations. The SEC found that when the offerings were integrated, aggregate sales were made to 64 non-accredited investors. This cost the hedge fund its exemption under Regulation D. For this reason the SEC held that the issuer had sold securities in a public offering and they were not registered as required by Section 5 of the 1933 Act. Thus, the offering violated Section 5 of the 1933 Act.

The loss of the private offering exemption also meant that the integrated fund had not complied with the “no-public-offering” requirement of section 3(c)(1). In addition, the SEC found that when the entities are integrated, there are a total of 112 investors, and that meant that the fund had not met the second prong of section 3(c)(1), the less than one hundred person test. Without the exemption provided by Section 3(c)(1), the entity was an investment company required to be registered, and the failure to do so (and the subsequent failure to comply with the provisions of the 1940 Act) was a further violation.

Recognizing what appears to be the absence of a venal intent, the SEC limited its monetary sanction to a $20,000 fine, hardly massive by today’s standards, and then threw in a censure. Oh yes, they also added a cease and desist order. Now the respondents are facing years of “bad boy” disqualification from registrations and exemptions under most state blue sky laws, and under many aspects of the federal securities laws.

One interesting question raised by this case is “what led the SEC to pursue it in the first instance if no one was hurt and presumably no one was complaining?” Remember the attempt to qualify for the private offering exemption? Well, the SEC’s Order notes that the sponsors mentioned the offerings during radio interviews, and posted information regarding this project on their web site. The SEC viewed that as somewhat incompatible with a claim that there is no public offering under way. Perhaps the SEC staff was troubled by having their collective nose “rubbed” in what was going on. The terms of the consent Order specifically refer to the objectionable public dissemination of information about the securities.

In any event, we have been cautioning clients that hedge funds and the exemptions upon which they rely are a current hot issue at the SEC, and that the SEC is clearly pulling in the reins. We just want to take this opportunity to renew our caution to our colleagues and clients to exercise care when moving ahead into these activities.


1 In the Matter of Gerald Klein & Associates, Inc. and Klein Pavlis & Peasley Financial, Inc., 1933 Act Release No. 8595, 1940 Act Release No. 26986, July 8, 2005.


This Alert was written Terrance J. Reilly and Steven M. Felsenstein in the Philadelphia office. Please contact Mr. Reilly at 215.988.7815, Mr. Felsenstein at 215.988.7837, or your Greenberg Traurig liaison, if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig

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This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.